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The Wrong Way to Boost Revenues

Thursday, September 6, 2007

Why hiking taxes on private equity and hedge fund managers would be counterproductive.

The Wrong Way to Boost RevenuesToday, the House Ways and Means Committee will meet to consider an overhaul of the American tax system. On the table will be a proposal to increase the tax rate on carried interest payments to private equity and hedge fund managers from 15 percent to 35 percent (plus Medicare payroll taxes). It’s a big hike with big implications—and one that legislators should be wary of endorsing. 

Under the Internal Revenue Code, the rule has always been that carried interest payments to managers are taxable as capital gains, not as earned or other income. There are three reasons for this. First, we seek to reward and incentivize risk. Second, carried interest payments correspond to increases in asset value (capital gains). Third, they are made to individual members of partnerships, which, unlike corporations, are not distinct from their members, so the personal capital gains tax rate applies. 

But the new proposal, introduced by Congressman Sander Levin of Michigan and backed by Ways and Means Chairman Charlie Rangel of New York, would revamp the tax code so that carried interest payments are taxed like earned income at the higher rate, rather than as personal capital gains at the 15 percent rate. Meanwhile, Senators Max Baucus of Montana and Charles Grassley of Iowa (the top Democrat and Republican, respectively, on the Senate Finance Committee) have proposed a more limited tax-hiking plan. 

The Baucus-Grassley scheme would tax publicly-traded investment partnerships at the 35 percent, high-end corporate tax rate. Dismissing that plan as unfair to private equity and insufficient in terms of its revenue-raising potential, Senator Charles Schumer of New York prefers legislation that would subject carried interest from publicly-traded and private partnerships in all industries to ordinary income tax rates. His plan may have been conjured up as a poison pill—Schumer, after all, counts Wall Street among his constituents—but it must appeal to politicians intent on soaking the richest Americans. 

The proposed tax hikes would generate very little extra revenue. Investment firms might simply restructure their affairs to avoid the higher rates of tax.

Without a doubt, private equity and hedge fund managers fall into that category. According to a report released last week by the Institute for Policy Studies and United for a Fair Economy, the top twenty private equity and hedge fund managers in America took home an average of over $650 million each in 2006—a mind-boggling amount, which the report says corresponds to 22,255 times the average U.S. salary. An April Gallup survey indicated that a plurality (49 percent) of Americans want to “redistribute wealth by heavy taxes on the rich,” so it’s a safe bet that none of the various proposals to raise taxes on these managers will face popular disapproval. 

But they’re still a bad idea.

As Michael Knoll, a law professor at the University of Pennsylvania, has pointed out, the proposed tax hikes, if implemented, would generate very little (if any) extra revenue. At most, Knoll estimates that the value of increased amounts flowing into IRS coffers could be $3.2 billion—but it could be far less than that if, as he anticipates, investment firms simply restructure their affairs so as to avoid the higher rates of tax. 

Even if partnerships do not restructure, the consequences could be harmful. In a paper published this past January, Heritage Foundation scholar Brian Riedl concluded that President Bush’s 2003 tax cut, which reduced the top rate of capital gains tax to 15 percent, more than doubled capital gains tax revenue. (Riedl also found that it played an important role in driving economic growth and creating new jobs.) The Wall Street Journal editorial page recently noted that the amount of tax paid by those earning more than $1 million a year actually increased 78 percent between 2003 and 2005. If one objective of the Levin, Baucus-Grassley, and Schumer proposals is to boost revenues and soak the rich, those figures suggest that raising taxes on carried interest payments received by private equity fat cats might be counterproductive. 

It could also restrain investment and economic activity. Over recent years, private equity, specifically, has shown a willingness to invest in industries that few other investors would even look at. Witness, for example, Cerberus’s acquisition of Chrysler, a big employer described as “beleaguered” prior to its takeover. Given the pervasive worries about America’s manufacturing decline, buyouts like that should be encouraged—and tax hikes are not the way to do it. 

For that matter, who invests in private equity and hedge funds? Sure, the super-rich do, but so do pension funds, especially those established for state employees, who seek out private equity and hedge funds because of their high rates of return. When managers have to foot a higher tax bill, state pensions funds may bear at least part of the burden. That means less money for public-sector retirees—something that is bound to prove unpopular. 

Perhaps, after a month of vacation, legislators will have done the math and recognized the multiple problems presented by the tax-hiking schemes on offer. We’ll find out today. 

Liz Mair is a recovering corporate finance lawyer, and a columnist, commentator, and political consultant operating out of Arlington, VA. She writes daily at www.lizmair.com.

Image credit: photo by flickr user Chloe N.

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